Industrials: Weak Commodity Prices Weigh

• Demand for agricultural equipment and machinery has softened due to weakened crop prices. North American buyers lack interest at current prices, and many have been able to delay replacing exhausted equipment fleets. Farm income has dropped in many European nations, and uncertainty arising from Brexit has lessened the urgency to make large purchase orders.
• Rail traffic throughout North America continues its yearlong weakness. Total traffic year-to-date is down approximately 7%, with both intermodal units and carloads lower than in the previous year. As volume headwinds persist, freight haulers have focused on maintaining profitability through incremental price increases and managing labor costs.

The industrials sector remained fairly flat over the third quarter, and a top-down view of the sector leaves a lot to be desired. Depressed commodity prices came with hesitation and fear from investors, and manufacturing numbers in many different regions look dreary. Less than 20% of our coverage list trades in 4-star or 5-star territory. Not many companies are trading at material discounts to our fair value estimates, and we believe many companies are trading at values not backed by fundamentals.

Short-term headwinds have made prospects cheaper for M&A activity, but we do not see many opportunities where synergies will be quickly realized. However, our list does have areas with growth potential, and we envision upside from current prices for three stocks we highlight this quarter: The industrial distributor

Weakened crop prices have made the environment increasingly more difficult for agricultural equipment manufacturers. A drop in farmers' income has lessened willingness and the allure of new equipment. The United States Department of Agriculture is forecasting net farm income to be down double digits from last year. This would mark a third consecutive year of decline for the key indicator. European agricultural demand is pointing toward modest sales declines, and political and currency volatility exacerbate problems for farmers in South America. To combat depressed global demand, agricultural equipment manufacturers have showcased lower price points and machinery with enhanced capabilities. For example, telematics and software components allow a farmer to increase productivity during these trying times.

With uncertainty in the near future and crop prices depending on a plethora of variables, management teams and buyers are hesitant to lay out a recovery timeline. However, we believe long-term factors provide upside to the space. Calorie consumption is growing, and emerging countries have shown increasing willingness to utilize agricultural mechanization. Various regions across the globe maintain staunch support for government crop insurance and subsidy programs, and producers of seeds and pesticides are continuously working to increase crop productivity. Thus, although short-term headwinds are clear and causing unrest, latent pockets of optimism lead us to conclude undervalued opportunities are present for stakeholders.

Low sales also trouble North American railroads. Total carloads and intermodal units are down year to date approximately 10% and 3%, respectively. Exacerbating the decreased shipments, carloads carrying coal, petroleum products, and metals and metallic ores are each experiencing double-digit declines from the previous year. Low natural gas and oil prices continue to constrain coal and crude shipments. Our long-run optimism concerning intermodal container volume offsetting coal declines has been stymied this year, but we still think this is the secular growth engine for the rails.

The railroads have maintained or improved operating ratios by improving rates they charge shippers. Price increases can be achieved during tough economic times due to cost advantages over other transportation modes, and many shippers have few options. Another focus is driving out costs. Railroads have reduced workforce counts and locomotives to match lower volumes, and some have reduced capital expenditures modestly from initial 2016 budgets. Throughout the cost cuts, management continues to focus on high-quality service and operational excellence to position their companies for volume recovery that we expect in the next six to 18 months. Volume malaise and decreased commodity prices have posed insufficient concern to threaten our moat ratings, or dramatically transform long-term sector fundamentals. Extensive track networks form staggering barriers to entry that we expect to remain high, fending off economic moat deterioration.

Top Picks

Chicago Bridge & Iron

CBI

Star Rating: 3 Stars

Economic Moat: None

Fair Value Estimate: $41.00

Fair Value Uncertainty: High

Five-Star Price: $24.60

In the present subdued capital-spending environment Chicago Bridge & Iron has demonstrated the ability to win multibillion-dollar petrochemical, refining, and LNG projects over the past few years. It focuses on larger and more complex development projects, for which only a handful of E&C firms typically compete. CBI's vertical integration is aligned with rising customer preference for a single contractor able to exert broad control over large projects. The difficult decision to exit its nuclear construction business late last year removed a major uncertainty weighing on shares. We believe a spark of recovery in energy spending would reveal the company's core strengths.

United Technologies

UTX

Star Rating: 4 Stars

Economic Moat: Wide

Fair Value Estimate: $122.00

Fair Value Uncertainty: Medium

Five-Star Price: $85.40

We project commercial aircraft in service will double over the next 15 years. United Technologies' Pratt & Whitney re-entry into the narrow-body market creates a catalyst to drive future profitability. A healthy batch of orders for the innovative geared turbofan engine helps secure a long runway of aftermarket services. We expect these higher-margin recurring services will generate significant cash, and we believe the current share price offers investors a margin of safety. In our view, the market underappreciates the longer-term value of this fledgling program.

WESCO International

WCC

Star Rating: 3 Stars

Economic Moat: Narrow

Fair Value Estimate: $69.00

Fair Value Uncertainty: Medium

Five-Star Price: $48.30

WESCO believes it only sells to approximately 1% of global industrial distribution end markets, and recent acquisitions have allowed the distributor to expand its non-United States reach. We believe global growth will allow it to capitalize on network effects and increase free cash flow at a mid-single-digit rate. The company's role as a middleman serving a fragmented customer base and a large number of vendors increases the importance of its services.

More Quarter-End Insights

Stock Market Outlook: A Little Too Buoyant?

Credit Market Insights: Leaving Brexit Behind

Basic Materials: China-Dependent Producers Largely Overvalued

Consumer Cyclical: Poised to Perform in the Second Half

Consumer Defensive: A Handful of Values in an Overheated Sector

Energy: Rally in the Works, but It Won't Last Long

Financial Services: Berkshire Is Bigger Than Buffett

Healthcare: We See Value in the Drug and Biotech Industries

Real Estate: Expect Some Choppy Waters Ahead

Tech & Telecom: Opportunities in Smartphones and IT Services

Utilities: How Long Can the Yield Paradox Survive?